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What Is a Penny Stock?

Don't be fooled by the low price per share. Investing in penny stocks means diving into potentially dangerous territory.

Buying stocks can be somewhat of a risky proposition. Even large, established companies' stock prices have a way of plunging when the market goes south. But buying an established company's stock is generally considered less risky than buying penny stocks. Though the appeal of investing in penny stocks lies in the potential to generate huge profits by identifying an eventual winner, many investors in penny stocks ultimately wind up getting burned. Penny stocks started out as those that traded for less than a dollar per share, but over time, the term has been modified to encompass all stocks that trade below $5 per share. Not only are the companies behind penny stocks typically speculative in nature, but their stocks also trade over the counter, which means they're not listed on a major public exchange. There are a number of risks associated with penny stocks that make many investors want to steer clear.

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Lack of public information

A good way to make an informed decision about a stock investment is to gather information on the issuing company. This includes reviewing financial statements and other such documentation that public companies are required to file as per regulations imposed by the Securities and Exchange Commission. Penny stocks, however, aren't listed on major exchanges and therefore aren't subject to the same rules as larger companies. As such, there's little information about them available to investors, and the information they do release is not nearly as regulated or scrutinized as that of larger companies.

Lack of history

Many of the companies behind penny stocks are fairly new, so they have very little history behind them. It becomes more difficult to predict a company's long-term performance when there's minimal data on it to analyze.

No minimum standards

To be listed on a major exchange, a company must fulfill certain financial requirements. These minimum standards cover aspects such as stock price, total market value, number of shares, and number of shareholders. Companies whose stocks trade over the counter, however, are not required to meet the same criteria. These standards were put in place to protect investors, so buying stocks from companies that aren't subject to minimum standards increases the risk factor.

Low liquidity levels

Penny stocks are typically harder to sell than stocks that are listed on major exchanges. Therefore, those who hold penny stocks are often forced to offer their shares at a lower price to attract buyers, which increases the chance of taking a loss. Additionally, because penny stocks have limited liquidity, it opens the doors for traders to manipulate pricing. This typically plays out in a strategy known as pump and dump, where investors will heavily promote a stock (often via false or misleading information about the issuing company) in an attempt to boost its price. Once the stock's price climbs, they'll dump it, and those who bought at a higher price will lose money once the price per share falls again.

While there is money to be made in penny stocks, they're a risky prospect for many investors, especially those who are new to the market. The best way to avoid losing money on penny stocks is to research issuing companies extensively before jumping in and buying their shares.

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